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Two Presidential Candidates With Unique Tax Plans

OCEAN CITY – With the economy ranking No. 1 on voters’ list of concerns, the topic of taxes is coming up with increasing regularity in debates and on the campaign trail. It’s clear that the 44th president will greatly affect future tax policy and, by extension, your pocketbook and investment portfolio.

The parties have very different approaches, as evidenced by their candidates’ positions. Republican presidential candidate John McCain, for instance, proposes making President George W. Bush’s tax cuts permanent. He also wants to make it harder to raise taxes. His Democratic challenger, Barack Obama, is equally vocal about repealing those tax cuts for households earning more than $250,000.

Here’s where the candidates stand on these issues and how their proposed changes might affect you.

With Bush’s tax cuts scheduled to expire in 2011, Congress will be under pressure to pass legislation to extend or replace them. Senator Obama’s plan to eliminate these cuts would increase income taxes for those in the highest two brackets and push the top marginal rate on ordinary income from 35% to 39.6%, according to William Ahern, spokesman for the Tax Foundation, a nonpartisan tax research group, who adds that Democrats have proposed much more new spending than could be paid for by the tax increases they’ve discussed. Therefore, Ahern says, “they are likely to seek even higher taxes.”

In contrast to his Democratic rival, McCain not only intends to make the Bush cuts permanent, he has also said he would reduce the corporate tax rate, now 35%, to 25% in a bid to stimulate the economy.

The alternative minimum tax (AMT), which adjusts tax liability upward for many individuals who take tax deductions, has been affecting more taxpayers each year. This year’s adjustment to index the AMT to inflation cost taxpayers a staggering $63 billion. McCain has said he would phase out the AMT. Obama voted not to repeal it but has yet to provide more detailed plans on the tax everyone loves to hate. Still, as costly a headache as the AMT has become, few tax experts expect it to disappear under either a Republican or a Democratic president. The reason: Eliminating the AMT would create a huge gap in the federal budget that no candidate has yet to justify.

The Democratic candidate favors raising the current 15% rate on long-term capital gains and dividends to 28%, where it was from 1991 to 1997.

“Raising the rate would lower after-tax returns on equities and reduce high-end consumption, which could put a damper on the stock market,” says David Rosenberg, Merrill Lynch Chief North American Economist.

Obama also advocates treating dividends as ordinary income.

“Many Democrats think those rates are too high,” says Steven Sheffrin, dean of social sciences at the University of California–Davis, who notes that McCain has pledged to keep current rates on dividends and capital gains right where they are.

Any increase in the tax on dividends would worry Raj Chetty, professor of economics at UC-Berkeley, who has studied how corporations respond to a favorable dividend rate.

“When rates are low, companies pay out more retained earnings as dividends,” Chetty says. “And dividends spur economic growth as investors plow the money back into other companies.”

Chetty and others point out that no candidate has yet proposed a definitive solution to the elephant in the room: the huge deficits being racked up by Medicare and Social Security as the wave of baby boomers prepares to retire. But many experts think higher taxes are inevitable to pay for those social entitlement programs.

Don’t expect much money for entitlements to be generated by a reinvigorated estate tax, says Rosenberg. After being temporarily eliminated for 2010, the estate tax is slated to jump to 55% on estates of more than $1 million starting in 2011. Though neither of the candidates has proposed eliminating the tax permanently, McCain has called for higher exemption levels and lower estate tax rates. He would also like to see a 15% estate tax with a $10 million exemption for couples. Obama has yet to provide any specifics.

There are clearly marked differences between the two parties—and some surprising areas of agreement. Both candidates, for instance, have proposed new ways to ease the tax burden for the middle class and working poor.

They will argue their viewpoints, and, come November, the voters will have their say. But practically speaking, just how much power the next president will have to effect real change depends on which party wins. With the Republicans expected to lose seats in the Senate and the Democrats likely to remain in control of the House, “a Democratic president may have a bit more sway in advancing tax policy, whereas a Republican president could face a stalemate,” predicts Sheffrin.

No matter what happens, investors would be wise to consider the implications of a new administration and discuss the possible effects on their portfolios with their Financial Advisors.

(A Merrill Lynch Senior Financial Advisor who can be reached at 410-213-8520.)